Investment Appraisal, Interpretation of the Calculated Ratios, Activity-Based vs Traditional Costing - Case Study Example

Case Studies: Finance and Accounting Contents I. Introduction 3 II. Case Study 3 II. I. Recommendation on Project Selection 3 II. II. Critical Discussion of Investment Appraisal Methods 3 II. II. I. Payback Period 3 II. II. II. Accounting Rate of Return 4 II. II. III. Net Present Value 4 II. II. IV. Internal Rate of Return (IRR) 5 III. Case Study 2 6 III. I. Interpretation of the Calculated Ratios 6 III.I.I. Profitability Ratio 6 III.I.II. Liquidity Ratio 6 III.I.III. Working Capital Management Ratio 7 III.II. Limitations of Relying too Heavily on Financial Ratios 7 IV. Case Study 3 8 IV.I. Difference between Activity based Costing and Traditional Costing 8 V. Conclusion 8 VI. Reference List 9 VII. Bibliography 10 I. Introduction Finance and accounting is a critical aspect for any organization operating in the contemporary business scenario. Therefore, decision making in this regard requires considerable attention for the financial consultant of the company to give emphasis on every single details in order to arrive at accurate and error free long and short term decisions. In this paper, being a financial consultant of NENE Limited, clarifications should be provided to the directors of the company as they are facing difficulties regarding decision making in various financial aspects as mentioned in the three case studies. All these three problems will be addressed separately due the course of the paper. II. Case Study 1 II. I. Recommendation on Project Selection Considering the result provided by the investment appraisal techniques, it is clear that between the two mutually exclusive investment projects named Alpha and Beta, NENE Limited should consider the project Alpha for financing. Considering the Projected Cash flows, the calculations show that the cumulative cash inflow Alpha is projected to incur £105,000 at the end of sixth year whereas project Beta is expected to earn £83,000 within the same time horizon. If Payback period is used as a technique for appraising investment proposals, calculations have shown that Alpha will be able to cover its initial investment within 2 31/38 of time. However, though initial investment is less than that of Alpha, Beta will take 3.7 years to cover the initial investment. Accounting rate of Alpha is calculated to be 29.4%.whereas it is only 1.6% for Beta. One of the most important techniques NPV has shown that the present value of all future cash flows of Alpha accounted for £36,661 and Beta is £29,297. Therefore, as a financial consultant of NENE Limited, it can be recommended that Alpha is a better investment option for the company, as compared to Beta (Shapiro, 2008). II. II. Critical Discussion of Investment Appraisal Methods II. II. I. Payback Period Payback period indicates the number of years required for covering the initial cash outlay that was invested at the beginning of the project. Payback period = (Cost of Initial Investment / Annual Net Cash flow) This investment appraisal method is widely used as a yardstick for comparing the profitability of two projects as it is easy to understand and calculate. However, the system involves a large number of drawbacks. First, according to Dayananda (2002), payback period concentrates only on recovering the initial capital. It does not take into account the scope for future profitability that the firms can earn over a period of time. Many other important considerations such as risk of financing and opportunity cost of financing one project at the expense of ignoring the other, has also been disregarded. Therefore, most of the economists have agreed on the fact that those methods that incorporate weighted average cost of capital for appraising investment proposal such as NPV and IRR are preferred over PBP method of investment appraisal (Baker and English, 2011). Complexity also arises when the cash flow changes multiple times due to the course of project life. Moreover, the system does not recognize time value for money and ignores the fact that profitability occurs on the number of years it is going to operate after the payback period. II. II. II. Accounting Rate of Return The method tends to express the average annual profit, after payment of tax, as a percentage of investment (Penman, 2012). Accounting Rate of Return= (Average Annual Profit after Tax / Average Investment) x 100 Though the method is simple to calculate and all required information is readily available, it also inherits some underlying difficulties. According to Böhm (2008), the system ignores the timings of cash inflow and out flow as it is based on accounting income statement instead of cash flows. Moreover, Bagad (2008) has argued that competing projects generally have varying length of lives. Hence, averaging out the net earnings of the projects, ARR fails to recognize the ability of earning of the project with longer life (Penman, 2012). II. II. III. Net Present Value Under the method, the required rate of return (ROR) is used as a discounting factor and the net cash flows are discounted by that ROR to arrive at their present values. Then the initial investment is subtracted from the aggregate of present values of the cash inflows. If the result is greater than zero, the project is accepted and if it is less than zero, the project is rejected by the company. Though according to some of the experts, NPV is regarded as the most reliable technique for appraising investment proposal as it involves time value of money, Jackson, Sawyers and Jenkins (2008) contradicted the proposition on the ground that NPV tends to calculate present value of cash inflows based on the assumed discount rate. As the discount rate is used in the denominators of each positive and negative future values in order to arrive at the present values (PV), the computation process becomes very critical. In fact, small changes in the discount rate may lead to affect the value of present cash inflow to a great extent. Moreover, it may also happen that the investment proposal inherits different level of risks during different time horizon in its entire life. Hence, using different discount rates for calculating effectiveness of the investment at different time makes the computation process more complex. Therefore, certainly NPV is a sound option for appraising investment proposal but it is not the best, error free and cannot be relied on for all investment decisions. II. II. IV. Internal Rate of Return (IRR) According to Khan (2011), internal rate of return indicates that discount rate at which the net present value of the investment becomes zero. The technique tends to equate the present value of the future cash flows with the amount of initial investment. Therefore, for two mutually exclusive projects, the one with higher IIR should be accepted. Most of the economics are of the opinion that IRR is one of the best techniques for investment appraisal as it provides clarity to the finance managers to understand the opportunity cost of the company and facilitates controlled financial accretion. However, financial experts such as Rich, Jones, Heitger, Mowen and Hansen (2011) have shown that the concept of IRR is largely based on the assumption of discount rate or cost of capital. Moreover, depending upon the different levels of cash flow in different years, there can be multiple IRRs for a single project. This creates complexities for the finance manager in decision making. III. Case Study 2 III. I. Interpretation of the Calculated Ratios III.I.I. Profitability Ratio Profitability ratio indicates the capacity of a firm to earn profit after covering its costs and expenses associated with the business process. Such ratios can be used as a benchmark for analysing performances of other companies. Three types of profitability ratio such as return on capital employed (ROCE), net profit margin will be evaluated for comparative analysis of the performances of Benjamin Ltd and Peters Ltd. Return on capital employed indicates the degree of return that the business can achieve from the level of capital employed by the company (Maher, Stickney and Weil, 2011). ROCE = Earnings before Interest and Tax (EBIT) - (Total Assets – Current Liabilities) Therefore, the higher is the ROCE ratio, the better it is for the future of the company. Calculations have shown that the ROCE of Benjamin Ltd is 23.81% and the same for Peters Ltd is 34.09%. Hence, from this parameter it is evident that acquiring Peters Ltd will be more profitable for NENE Limited. Considering gross profit margin that shows the ratio between gross profit and sales revenue for a company, the outcome illustrates that the ratio for Benjamin Ltd is 25.00% and it is 20.00% for Peters Ltd. This indicates that though both the company employs a sound gross profit margin ratio, the earnings of Benjamin Ltd has exceeded the cost of producing goods and services more proficiently. In this type of ratio, net income of a company is presented as a percentage of sales revenue. Considering this parameter, the ratio is identical for both the companies and is equal to 12.50%. Therefore, depending on the profitability ratios of both the companies, NENE Limited is suggested to acquire Peters Ltd (Sinha, 2009). III.I.II. Liquidity Ratio Liquidity ratio signifies capability of a company to meet its short term obligations through using the current assets. Generally it is assumed that a liquidity ratio between 1 and 3 shows sound financial health of a company. Liquidity ratios of Benjamin Ltd and Peters Ltd are 6 and 2.25 respectively. These ratios indicate that Benjamin Ltd is experiencing problem in short term financing which in turn will affect the company to manage its working capital efficiently. However, an efficient liquidity ratio of Peters Ltd shows strong financial health of the company and its ability to meet short term business requirements as well (Atrill and McLaney, 2012). III.I.III. Working Capital Management Ratio Under working capital management ratio, inventory days indicate that the number of days a company requires for selling all its inventories. For Benjamin Ltd, inventory days required is 97 whereas for Peters Ltd, it is 67. Therefore, Peters Ltd will take less time to sell all its inventories. Trade receivable days that shows how quick a company can generate cash from its business, is also lower in Peters Ltd (61 days) as compared to Benjamin Ltd (114 days). Finally, trade payable days show a company’s ability to pay its suppliers as early as possible (Sinha, 2009). Considering this parameter, calculation shows that Benjamin Ltd (30 days) pays its suppliers earlier than Peters Ltd (37 days). As most of the financial ratios indicate that the present financial position of Peters Ltd is stronger than Benjamin Ltd, NENE Limited should go for acquisition of Peters Ltd. III.II. Limitations of Relying too Heavily on Financial Ratios Though the financial ratios are used for obtaining a clear understanding of the financial health of a company, relying too heavily on such ratios may result a firm to witness the following difficulties. Financial ratios are analysed on the basis of information obtained from financial statements (Banerjee, 2014). Therefore, if the underlying accounting system is under suspect, the ratios are bound to yield deceptive numbers. Companies are involved in different industries as well as uses different accounting standards and techniques (LIFO and FIFO). Hence, interpretations are not changed according to the industry-averages; the firm will end up with defective financial analysis (Needles, Powers and Crosson, 2010). Moreover, the consideration of inflation badly distorts the balance sheet of the companies, affecting the profitability of the firms which in turn is reflected in the financial ratios. Seasonal factors also tend to procure misleading results. For instance, a retailing company intentionally keeps the inventory high during festive seasons to meet the additional demand (Gowthorpe, 2011). This will create an adverse effect on financial ratios and indicate a low return on asset and high accounts payable which is genuinely misleading. While evaluating a company’s performance over a period of time, some of the ratios may show a good result while others may demonstrate an adverse financial situation. Therefore it becomes difficult to determine the actual financial position of the company (Jackson, Sawyers and Jenkins, 2008). IV. Case Study 3 IV.I. Difference between Activity based Costing and Traditional Costing Activity based costing identifies different activities associated with the business process of an organization and the cost assigned to each of such activities along with resource requirements with each products and services (Rajasekaran, 2010). In contrast, traditional costing tends to assign manufacturing overheads to each factor that involves certain amount of costs. Such cost drivers in traditional costing system includes labour and material hours etc. Therefore, activity based costing is a much more appropriate method of costing rather than traditional costing method. However, this type of accounting is very time consuming, complicated and it tends to increase the administrative and managerial cost of business to a great extent. Conversely, traditional costing is simple to calculate and does not involve complicated calculations. Hence, such type of costing saves the time and non-manufacturing expenses of the company as less expert concentration is required in this regard (Kinney and Raiborn, 2012). Therefore, if the directors of the company are interested in obtaining an accurate and error free costing, they should incorporate activity based costing method in the company structure. V. Conclusion Three case studies involved in this assignment deals with three different segments of finance and accounting. Analysing different techniques of investment appraisal and capital budgeting for NENE Limited helped the company to choose best project available for financing and expansion. Ratio analysis of two companies facilitated NENE Limited to arrive at a decision of acquisition of the company with stronger financial health. Finally, comparative analysis on two methods of costing assisted the company to select the most appropriate method of costing. VI. Reference List Atrill, P. and McLaney, E. J., 2012. Accounting and Finance for Non-Specialists. New Delhi: Pearson Education Limited. Bagad, V. S., 2008. Managerial Economics And Financial Analysis. New Delhi: Technical Publications. Baker, H. K. and English, P., 2011. Capital Budgeting Valuation: Financial Analysis for Todays Investment Projects. New York: John Wiley & Sons. Banerjee, B., 2014. Cost Accounting Theory And Practice. New Delhi: PHI Learning Pvt. Ltd. Böhm, A., 2008. Interpretation of Key Figures in Financial Analysis. Munchen: GRIN Verlag. Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Gowthorpe, C., 2011. Business Accounting and Finance for Non-specialists. Boston: Cengage Learning EMEA. Jackson, S., Sawyers, R. and Jenkins, G., 2008. Managerial Accounting: A Focus on Ethical Decision Making. Boston: Cengage Learning. Khan, 2011. Financial Management Text Problems Cases. New Delhi: Tata McGraw-Hill Education. Kinney, M. and Raiborn, C., 2012. Cost Accounting: Foundations and Evolutions. Boston: Cengage Learning. Maher, M., Stickney, C. and Weil, R., 2011. Managerial Accounting: An Introduction to Concepts, Methods and Uses. Boston: Cengage Learning. Needles, B., Powers, M. and Crosson, S., 2010. Principles of Accounting. Boston: Cengage Learning. Penman, S. H., 2012. An Evaluation of Accounting Rate-of-return. Journal of Accounting, Auditing & Finance, 6(2), pp. 233-253. Rajasekaran, V., 2010. Cost Accounting. New Delhi: Pearson Education India. Rich, J., Jones, J., Heitger, D., Mowen, M. and Hansen, D., 2011. Cornerstones of Financial and Managerial Accounting. Boston: Cengage Learning. Shapiro, 2008. Capital Budgeting And Investment Analysis. New Delhi: Pearson Education India. Sinha, K., 2009. Financial Statement Analysis. New Delhi: PHI Learning Pvt. Ltd. VII. Bibliography Chandra, P., 2010. Finance Sense 4/E. New Delhi: Tata McGraw-Hill Education. Drury, C., 2005. Management Accounting for Business. Boston: Cengage Learning. Jackson, S., Sawyers, R. and Jenkins, G., 2008. Managerial Accounting: A Focus on Ethical Decision Making. Boston: Cengage Learning. Khan, A. and Jain. B, 2007. Financial Management. New Delhi: Tata McGraw-Hill Education. Peterson, P. P. and Fabozzi, F. J., 2004. Capital Budgeting: Theory and Practice. New York: John Wiley & Sons. Tracy, A., 2012. Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. New York: RatioAnalysis.net. Weygandt, J. J., Kimmel, P. D. and Kieso, D. E., 2009. Managerial Accounting: Tools for Business Decision Making. Munchen: GRIN Verlag. Wilkinson, C. A., 2006. Capital Budgeting, Real Options and Escalation of Commitment: A Behavioral Analysis of Capital Investment Decisions. An Arbor: ProQuest. Read More